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Foreign Banks Stock Outlook - July 2012

Foreign banks have been adopting reconstruction-by-asset-sale as the means to reduce leverage and stay afloat. However, the industry remains thwarted by non-stop challenges that are keeping its performance under pressure.

Moreover, the upcoming quarters look even worse, with several negatives like asset-quality troubles, high borrowing costs, weak revenue growth, steeper expenses and weak loan demand. But thanks to worldwide regulatory reform, the sector has at least entered a transformation phase with the restructuring efforts. Needless to mention, a change is yet to be felt.

The sector showed less resilience in the first half of 2012 than anticipated. Growing concerns related to funding and limited access to markets along with other fundamental challenges are not expected to bring stability anytime soon.

On the Fundamental Side

Looking at the fundamentals, a rising risk-aversion tendency has been gradually reducing client activity, resulting in lower trading volumes and subdued credit demand. Also, learning from past experience, banks are now more cautious to lend money.

Consequently, lower business activities and anticipated subdued profitability are making foreign banks less attractive to investors. Valuation multiples of these banks will continue to reflect the fundamental challenges at least through the remainder of 2012.

Though the growth potential of some non-U.S. banks could be restrained due to higher reserve requirements and outsized losses related to capital markets, strict lending limits as part of the regulatory overhaul as well as greater transparency in regulations could strengthen the fundamentals of many banks. Eventually, these are expected to create a less risky lane for the overall industry.

As inter-country investment walls have fallen, some large non-U.S. banks are freely expanding beyond their domestic boundaries through mergers and acquisitions. On the other hand, regulatory pressure to focus more on the home market is forcing some global banking giants to sell overseas assets. These banks are naturally trying hard to restructure operations and address funding needs.

In fact, the sector saw a moderate recovery in 2010, but performance in 2011 was one of the poorest in its history. Difficulties notwithstanding, the financial crisis is finally behind us.

Primary Headwinds

Now the primary headwind for global banks is regulatory pressure, which ensued from taxpayers' money and government intervention that banks have relied on in order to remain in business. Moreover, government efforts to alleviate industry concerns have significantly raised political hurdles over time.

Politics will continue to influence lending decisions of banks for as long as these remain financially dependent on governments. According to banking regulators, if governments withdraw their support from banks before giving them sufficient time to restore their financial strength, the sector could collapse again. The need for bailouts is still felt prominently by the European banks.

The industry has been adopting tougher regulatory measures to prevent the recurrence of a global financial crisis and restore public confidence. In June 2011, the oversight body of the Basel Committee on Banking Supervision proposed new rules that would force the world's biggest banks to hold extra capital on their balance sheets as protection and prevention against any financial catastrophe. This extra capital requirement is an added cushion to the set of minimum capital standards under Basel III.

With these regulatory measures, the individual capital structures of banks will remain under constant pressure. The resulting slowdown at some big banks could be seen as a blessing in disguise, as it would eventually make their balance sheets more recession-proof.

Valuations Look Attractive

Balance sheet repair and credit environment recovery will make the valuations of some non-U.S. banks attractive. Particularly, valuations of the mega banks, which could comfortably maintain the minimum capital norms mandated by the Basel Committee, will experience the fastest valuation upside. Consequently, we believe this would be a good time for long-term investors to consider foreign bank stocks, as now the valuations look comparatively cheaper.

Investors with short-term targets, however, should be watchful while choosing foreign bank stocks at this point as near-term fundamentals remain weak. Asset quality lacks the potential to rebound anytime soon as default rates for individuals and companies are not expected to materially subside, and revenue growth might remain weak with faltering loan growth.

The sector is not expected to witness a turnaround at least in 2012. If any improvement occurs, it will vary from country to country, depending on industry circumstances.

Ratings Concerns

Ratings downgrades are a major threat for major global banks. In July 2012, Moody’s Investors Service downgraded credit ratings of 15 systematically important banks in the U.S., U.K. and Europe. The foreign banks include the likes of Barclays plc ([url=https://www.zacks.com/stock/quote/bcs]BCS[/url]), Credit Suisse Group ([url=https://www.zacks.com/stock/quote/cs]CS[/url]), HSBC Holdings plc ([url=https://www.zacks.com/stock/quote/hbc]HBC[/url]), Deutsche Bank AG ([url=https://www.zacks.com/stock/quote/db]DB[/url]) and UBS AG ([url=https://www.zacks.com/stock/quote/ubs]UBS[/url]).

The downgrade was based on the agency’s concern related to these banks’ significant exposure to the volatility and expected losses from capital market activities. This rating action could compel many of these banks to post billions in additional collateral, which will make derivative trading costly. Also, already-high borrowing costs for these banks will create a further increase.

Eurozone Woes

European banks are most likely to underperform in the upcoming quarters, primarily due the ongoing debt crisis in the region, resulting capital pressure and deleveraging risk.

In early 2010, the debt crisis originating in the Greek economy shook the stability of the European Union's (EU) monetary policies. Starting as a solvency crisis in a single country, the turmoil spread over to the entire Eurozone.

The situation did not stabilize to a great extent in 2011, despite financial assurance from EU leaders. In 2012, the European debt crisis has heightened, spreading fears of a financial collapse on the continent.

Though the funding situation in Europe has improved to some extent with huge aid from the European Central Bank, there remain deep concerns related to the banks’ ability to meet capital requirements.

Italy and Spain showed signs of improvement with support from the government and European Central Bank, but conditions in Greece remain uncertain due to issues related to additional bailout funds.

Moreover, the high inflation rate will continue to force regulators to tighten their policies in the Eurozone, making banks less flexible.

Overall, the European Union is trying hard not just to restore investor confidence but also the health of the continent’s banking system. The issue, however, remains far from being addressed.

Emerging Markets

Coming to banks in emerging economies, the asset quality trouble is obvious. However, these are not plagued by other serious problems that many of the larger banks face in continental Europe and the United Kingdom, such as toxic securities and dilution from capital raising. Moreover, these emerging-market banks generally tend to be well capitalized, aren't as heavily exposed to property markets, and have significant and growing sources of non-interest income.

We believe that banks in emerging economies –– Chile, Brazil and India –– look more attractive, akin to certain regional banks in the U.S., Australia and Canada that have capital strength, good funding and growth potential.

Conclusion

Overall, a key determinant for a quick recovery will be the quality of risk analysis and risk-awareness in decision-making and incentive policies. So, we believe that accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial to banking performances.

Also, the primary attention of policymakers should be on determining how much longer fiscal stimulus should continue, ensuring that it is not withdrawn before a clearer sign of economic recovery is visible.

We also like a few Zacks #3 Rank stocks such as Bancolombia S.A. ([url=https://www.zacks.com/stock/quote/cib]CIB[/url]), Banco Santander, S.A. ([url=https://www.zacks.com/stock/quote/san]SAN[/url]), HDFC Bank Ltd. ([url=https://www.zacks.com/stock/quote/hdb]HDB[/url]), KB Financial Group, Inc. ([url=https://www.zacks.com/stock/quote/kb]KB[/url]), The Royal Bank of Scotland Group plc ([url=https://www.zacks.com/stock/quote/rbs]RBS[/url]) and The Toronto-Dominion Bank ([url=https://www.zacks.com/stock/quote/td]TD[/url]).

WEAKNESSES

We would suggest avoiding European banks at this point, including banks in Great Britain and Ireland -- in particular, those that have participated in government recapitalization programs and have yet to repay. In return for government capital and asset quality protection, these banks are facing regulatory intervention, like enforcing limits on dividend payouts and board member nominations.

We also dislike some stocks in the non-U.S. bank universe with the Zacks #4 Rank (Sell), namely Royal Bank of Canada ([url=https://www.zacks.com/stock/quote/ry]RY[/url]), ICICI Bank Ltd. ([url=https://www.zacks.com/stock/quote/ibn]IBN[/url]), Canadian Imperial Bank of Commerce ([url=https://www.zacks.com/stock/quote/cm]CM[/url]) and The Bank Of Nova Scotia ([url=https://www.zacks.com/stock/quote/bns]BNS[/url]).

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